Newsletter – August 2015

Following Monday’s 4% fall, our share market was down by 16% from its April 2015 peak. European markets are down by a similar percentage and the US market is down around 14% so naturally this is making many investors very nervous.

There are a number of factors behind this but the first thing to say is that “corrections” are normal and generally happen every year or two so, in that sense, it is not wholly unexpected. This is, however, now a severe correction. Long term investors should generally ride out these periodic corrections but want to understand what has triggered the sharp sell off. Following on from that is whether this represents a buying opportunity or a time to be reducing share market exposure before things get even worse.

There is seldom one factor contributing to a significant fall in the share market. The biggest factor at the moment is concern that China’s economy is slowing markedly and that this will impact other countries because China is now the 2nd largest economy, after the US, and a major trading partner for many countries, such as Australia.

Other factors negatively impacting investor sentiment include the generalised fall in commodity prices, in particular oil, fear of higher interest rates in the US (but nowhere else) and weak emerging market economies, such as Brazil, Russia & Turkey. Adding to this is the perception that valuations (share prices versus earnings) were stretched (too high) after the strong rally that has occurred since the GFC ended.

No-one can be certain that what we are experiencing is simply a correction or the start of something worse, but my feeling is that it is more likely a (significant) correction. In recent times, the Australian share market suffered falls of 15% between April and July 2010 and 22% between April 2011 and September 2011. Major falls of 25% or more, like that experienced in the GFC, are rare.

There are no clear signs of an imminent global recession – the US is growing strongly even if Europe and many emerging economies are weak – and share market valuations, particularly after this correction, aren’t at the extreme levels that typically precede market collapses. Most larger Australian businesses have strong balance sheets even if profit growth is weak. Also, credit markets aren’t under stress as during the GFC. Buyers of quality shares should be rewarded in the medium term but there is a possibility that the correction goes somewhat further in the short term. For the record, I am selectively buying some strong businesses remembering how rewarding that has been since the GFC.

Commodity Prices have fallen dramatically

The price of oil has fallen substantially over the past year, from above US$100 per barrel to around US$40 currently, and Australians should be aware that the price of iron ore has fallen even more dramatically from a peak of around US$180 per tonne to below US$50 currently. The prices of many other commodities, such as coal, copper and nickel, have also fallen substantially.

The Reserve Bank’s index of commodity prices below shows that the fall since the peak in mid 2011 has been very substantial, taking us back to the level last experienced in mid 2009, before China’s huge economic stimulus took prices much higher.

Australia headed for a recession?

Australia has not had a recession, normally defined as two quarters (six months) or more of negative economic growth, since 1991, the longest period in our history. However, some economists think that not only are we overdue but that the preconditions exist such that there is a significant possibility of a recession in the next year or two.

For example, Chris Watling, CEO of Longview Economics, says that “Special one-off factors have been a key underpinning of Australia’s current record expansion. A long run-up in household indebtedness, a strong rise in house prices, a commodity super cycle and an associated China infrastructure boom have all combined to extend Australia’s economic expansion beyond the length of a normal cycle”. He says that “ the key to forecasting the next Australian recession lies in forecasting the end of cheap money. This is especially true given that the other non-housing drivers of this record long economic expansion have gone into reverse”. If international markets pushed up the cost of funding to our banks, as occurred dramatically during the GFC, that would end “cheap money”.

While Australia’s economic expansion, now 94 quarters old, is the second longest expansion amongst the main developed economies (incorporating the G10 plus Australia) over the past 45 years (i.e. since 1970) and that our economy has some problems following the end of the mining boom, there is still only a modest probability of a recession in the next year or two. The lower AUD, now down to US$ 0.72, should assist the Australian economy. However, if China weakens more than expected and the cost of bank funding rises meaningfully then the possibility would rise significantly so I will be watching these things closely.

Reflections from my recent visit to China

I recently attended a financial planning conference in Beijing, my first time in that city, and while that most certainly doesn’t make me a China expert, I observed some interesting things and learned more from some interesting local speakers. Some random reflections are:

Property prices have boomed, particularly since the 2008 Olympic Games, creating significant wealth for some but making housing affordability a big issue, as it is in Australia.

The wealth effect from the huge growth in property prices has led to consumer demand for cars and other consumer goods; there are many luxury cars, particularly Audis, on the roads.

They have an excellent subway system which is just as well as with around 20 million people the traffic is often terrible. In the city it’s mostly cars these days with few push bikes.

You see relatively few foreigners, even at the touristy places like Tiananmen Square and the Forbidden Palace. There are a lot of Chinese!

The air quality is very poor – I hardly saw the sun in a week and they can only dream of a clear blue sky.

They are getting serious about addressing pollution – it’s in their interest to do so – and I visited a very large and impressive company producing very high tech solar energy equipment. However, it will take quite awhile before noticeable improvements occur.

Prices of clothes, food and the like are cheaper than in Australia, but not as dramatically so as you might expect unless you go to low quality places.

It feels safe, not dissimilar to our major cities.

China is very aware of its history and determined to reclaim what it sees as its rightful place as a leading nation of the world.

While there will be ups and downs in the economy – currently they seem to be entering a down phase – China’s growth will remain strong compared with developed Western nations for decades to come as hundreds of millions more migrate from the country to existing and new cities.

China is investing hugely to develop new land and maritime “silk roads” – connections to countries throughout Asia and across to Europe and Africa. This will promote trade and China’s influence in the world.

SMSF Pensions

The ATO Assistant Commissioner, SMSF Segment recently highlighted the following in regard to SMSF Pensions.

Commencing a SMSF Pension:

Make sure that the trust deed permits the trustee to pay the pension – older trust deeds may require updating.

Make sure that the member to whom the pension is to be paid is eligible to receive the pension – only those born before 1 July 1960 – have a preservation age of 55; everyone else has a preservation age of 56 or more.

Operating a SMSF Pension:

Make sure the minimum required pension is paid each financial year.

While pension shortfalls can be ignored in limited circumstances (e.g. underpayment is less than 1/12th of the required minimum and the underpaid amount is paid as soon as possible after the shortfall has been identified) trustees can only self assess this administrative concession once – thereafter it is the ATO which decides.

Liquidity management in pension phase must be carefully considered – particularly, if there is real estate.

In order to obtain the benefit of tax free earnings in pension phase, an actuarial certificate is required (except where the entire fund is in pension phase for the year).

Transfer of a SMSF Pension on death to a reversionary beneficiary:

The pension can only transfer on the death of the member.

The reversionary beneficiary must, from a SIS and Tax perspective, be eligible to receive a pension.

There is no recalculation of the minimum pension limit in the financial year in which the member dies – however, the minimum pension limit must be paid by the end of that financial year.

At the start of the next financial year the minimum pension limit will be determined, having regard to the age of the reversionary beneficiary.

If the pension payable to the member was a transition to retirement pension, then on the member’s death the preservation components of the pension account balance become unrestricted non-preserved – and the age of the reversionary beneficiary is irrelevant in relation to this aspect.

This newsletter contains general advice. It does not take account of your individual objectives, financial situation or needs. You should consider talking to a financial adviser before making a financial decision.